This Energy Producer Of The Denver-Julesburg Basin Has Gotten Ahead Of Itself

Introduction

Looking for the next hot Basin in the U.S., an investor will stumble upon the Denver-Julesburg (DJ) Basin where the dominant formation is the Niobrara shale. The industry is still in the early stages of unlocking the potential of the Niobrara and Codell formations in this Basin as different spacing densities within multiple formations are still being delineated.

Although the large caps always attract most of the attention in any play, there are also companies that are worth a deeper look because they might be good short candidates or potential buyout targets. One thing is for sure: Not all the shale plays are created equal, and Niobrara or Codell are not Bakken or Eagle Ford.

The Synergy Case

With this in mind, let's check out Synergy Resources(NYSEMKT:SYRG) whose operations are in the DJ Basin. Synergy holds 218,000 net acres, spread out in Colorado, Wyoming, Nevada and Kansas. In March 2012, the company participated in its first horizontal well that was drilled by Noble Energy(NYSE:NBL). That well wasn't a turning point for Noble whose production isn't solely dependent on the Niobrara shale. Noble Energy has greatly changed the Israeli economy during the last three years. In January 2009, Noble Energy discovered Tamar (36% WI) where the well encountered more than 600 feet of net pay in three high-quality reservoirs. Noble Energy discovered Leviathan (40% WI) in December 2010. Leviathan represented the largest deepwater natural gas discovery in the world over the past decade. It was Noble's third significant offshore natural gas discovery in the Levantine basin, following Tamar and Dalit.

Tamar, which came online in March 2013 with an estimated 10 tcf, can meet Israel's needs for decades. Leviathan, expected to begin production in 2016, is estimated to hold 19 tcf. In February 2012, Noble Energy discovered Tanin with estimated gross mean resources of 1.2 Tcf. Tanin is the fourth field over 1 Tcf that has been discovered in this Eastern Mediterranean basin.

However, that horizontal well was a turning point for Synergy, which has been developing the Wattenberg field vertically for some years now, targeting liquids rich natural gas in the Niobrara, Codell, and J-Sand formations. Noble's horizontal well showed a very encouraging result, opening up new liquids windows within the Niobrara formation and leading Synergy to participate in additional horizontal wells drilled by various operators during the remainder of 2012.

Digging Deeper Into Synergy

Synergy has been profitable for several quarters now, but apparently this is not enough to allure me to buy it. Synergy trades well above its book value (PBV=3) with a balanced production mix of 2,067 boepd (54% oil) in Q2 FY 2013, and holds proved reserves of 10.7 MMboe (August 2012). With Enterprise Value (EV) at $390 million, Synergy trades at a staggering $188,700/boepd and a whopping $36.45/boe of proved reserves.

In Q2 FY 2013, the long-term debt rose to ~$42 million due to the recent acquisition of Orr Energy that owned 360 boepd and 1,005 net acres in the Wattenberg Field. With estimated annual operating cash flow at $30-35 million for FY 2013, the D/CF ratio (annualized) is at ~1.3x which is decent. However, it must be pointed out that the long-term debt will rise further during the next quarters, to fund the Capex budget for FY 2013 which is estimated at $82 million.

It is also worth noting that Synergy's core areas are not heavily oil-weighted, but they weigh more on the dry gas and the natural gas liquids (NGL) production. This is why, Synergy has a balanced production mix (54% oil and 46% natural gas).

The dominant natural gas and NGL production in Synergy's area is also supported by the following two projects:

1) Enterprise Products Partners (NYSE:EPD) will team up with DCP Midstream Partners (NYSE:DPM) and Anadarko Petroleum (NYSE:APC) to construct the Front Range NGL Pipeline with plans to move 150,000 boepd in NGL from the DJ Basin in Weld County, Colorado, to Mont Belvieu, Texas. The capacity of this 435-mile pipeline can be expanded to 230,000 boepd, according to Enterprise Products Partners. The pipeline, which is expected to begin service in the fourth quarter of 2013, will help producers in the DJ Basin maximize the value of their NGL production by providing connectivity to the premium Mont Belvieu market.

More information combined with detailed maps about the Front Range NGL Pipeline and the other pipeline projects of Enterprise Products Partners are shown in my articles here and here, that discuss the "Silver Bullets of the North American Energy Transport Infrastructure."

2) NuStar Energy (NYSE:NS) initiated the Niobrara Falls project in October, 2012. The company planned to create a system of pipelines to carry crude oil from Colorado's Niobrara shale formation to refineries in Texas. This project had an initial binding open season from October 2012 until November 2012, which was extended to December 2012, and then to February 2013. NuStar has not released any news since February 2013, and what comes in mind is that NuStar must have problems in finding the necessary quantity of crude oil in Colorado to fill the projected pipeline capacity.

On top of that, Synergy has only 16,355 net acres at the liquids part of the highly touted Wattenberg field, which is obviously a small position and is less than 10% of its total acreage in the DJ Basin. A big portion of the company's acreage is located at the dry natural gas window of the DJ Basin, while the majority of the company's assets are located in Nebraska and have not been de-risked yet.

The potential buyers of Synergy need also to bear in mind Recovery Energy (RECV). Recovery Energy is a pure play of the DJ Basin where it holds 129,000 net acres. Recovery Energy has been unable to increase its production for months now, due to its poor results from its DJ basin acreage, including the Wattenberg field. This is why, its stock dropped significantly from $4.5 down to $1.5 in late 2012.

After all, the stock has surged disproportionately to the company's fundamentals and Synergy's key metrics are sky high for its balanced production mix.

If some folks wonder which energy producer is undervalued for me, they need to check out Surge Energy (ZPTAF.PK) for instance. Surge Energy is an oil-weighted producer of 10,000 boepd (73% oil and liquids), and I recommended it when it dropped at ~$3.6. That was when I made my first buy in late January 2013. When Surge dropped at ~$2.75, I added to bring my average down at $3, as disclosed. Surge Energy hovers at ~$4.8 today. I sold most of my position last week to lock a 50% profit in three months, but I still hold few shares to see how things will evolve. My two bullish articles about Surge Energy are here and here.

Instead of buying Synergy, those who want to buy companies with a balanced production mix to help mitigate the risk associated with any one commodity, they can check out Rosetta Resources (NASDAQ:ROSE) and Enerplus Corporation (NYSE:ERF). Both of them have much better key metrics than Synergy and they have also growth prospects.

As I discussed in my article here, Rosetta's acreage in Montana proved to be a dud, and the company was solely dependent on its Eagle Ford acreage until few weeks ago when it expanded to the Permian Basin.

Rosetta is a significant producer in the Eagle Ford shale in South Texas, targeting primarily the liquids-rich portion of the play. In Q1 2013, Rosetta produced 47,000 boepd (62% oil and liquids), holding proved reserves of 201 MMboe (58% oil and liquids). With EV at ~$3,06 billion, Rosetta trades at ~$65,000/boepd and $15.22/boe of proved reserves.

Enerplus has assets both in Canada and the United States. The company's assets extend from the Bakken/Three Forks resource play in North Dakota and the Marcellus shale gas region in the northeast U.S., to the liquids rich Deep Basin area of Canada and to conventional natural gas and oil production throughout the Western Canadian Sedimentary Basin.

In Q1 2013, Enerplus produced 87,183 boepd (48% oil and liquids), holding 227.3 MMboe of proved reserves. With EV at ~$4,4 billion, Enerplus trades at 50,500/boepd and $19.36/boe of proved reserves. The income seekers cannot also afford to overlook the company's hefty dividend of ~6.7% annually.

Looking Ahead

Synergy entered recently into a joint venture agreement with Vecta Oil & Gas, and increased its net acreage position in the Wattenberg field to 19,400 net acres.

A few days ago, Synergy commenced its operated horizontal drilling program on its Renfroe lease in the Wattenberg Field. Synergy's initial plan is to drill five wells from one pad site comprised of three Niobrara and two Codell wells. The wells will be approximately 4,700 feet in lateral length and Synergy anticipates there will be between 16-20 frac stages per lateral. The company has contracted with Ensign United States Drilling Inc., a subsidiary of the Canadian Ensign Energy Services (ESVIF.PK), to drill these wells.

Conclusion

Synergy is a junior producer with a largely unproven acreage and a huge premium in comparison to its peers. The company's current overly rich valuation can implode any time. In other words, the downside is limitless, while the upside is limited from the current levels. There are much cheaper energy producers out there, and Synergy is not my cup of tea.

Disclosure: I have no positions in any stocks mentioned, but may initiate a short position in SYRG over the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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